Foreign bonds should be a vital part of any properly diversified bond
portfolio for a variety of reasons. First, at various times there may
be foreign countries that offer higher interest rates, stronger currencies,
and stronger economies than the US, so much so, in fact, that at certain
times American fixed income products are generally a bad investment
relative to certain foreign bonds. I think that we are in such a period
right now. Secondly, the process of researching relative currency valuations
(c.f. the “Big Mac Index described below), foreign economic policies,
different inflation rates, and the trends in currency exchange rates
force an investment strategist to ask questions that he should be asking
any way even if he were restricted to only buying domestic bonds. Jim
Rogers, the investment “biker” writer at www.jimrogers.compoints
out that one often learns more about ones own country by being abroad
than by staying at home, and studying foreign currencies and different
national strategy issues works in a similar manner.

“WE’RE
MORE AMERICAN THAN AMERICANS”

Every now and then I run into a news article that carries this theme,
usually meant as a spoof, voiced by groups such as a Wild West reenactment
group in Germany, a 1950’s car and culture club in Norway, a U.S.
Cavalry horse club in Russia, or a group of descendants of Southern
Plantation owners who fled to Brazil in 1865 who still fly the Stars
and Bars at their 4th of July picnics.

However, there is a more serious economic, political, and demographic
dimension that is not quite so humorous. I explain in my “Learning
the score” article that the original economic and political philosophy
of America was strongly libertarian. There was no income tax and no
central bank,. There was almost no government, in fact, with less than
1/30 the number of government bureaucrats per capita compared to a European
country such as France at that time.

Most Americans are unaware of the extent that American has changed
in the last hundred years, and has turned its back on the basic free
market principles that characterized its earlier success. In a Forbes
interview in the late 1980s, Nobel Laureate Milton Friedman pointed
out that virtually every item on the 1928 Socialist plank has become
a reality in America today. In the early 1990s The Conservative Review
ran an article by J.V. Raehn which claimed that there were then more
de facto Marxists in America than in Eastern Europe. According to Raehn,
Eastern Europeans had experienced Marxism first hand and were totally
fed up with it, whereas in America, through a very subtle and incremental
process, Americans had come to accept as mainstream ideas that would
have been considered “Bolshevik” in the 1920’s and
were not even aware of it.

Although America once led the world in manufacturing prowess, Japanese
firms adopted and perfected many innovations pioneered by Americans
such as W. Edwards Demming
in the 1950’s that were initially ignored by major American companies.
They redacted these ideas back to Americans while taking away major
market share. As discussed in my “Learning the score” section,
the early American approach to economics has been redacted back to us
by the “Austrians.” We are often hit with ironies such as
Steve Forbes’ remark in the April 15, 2002 Forbes Magazine Fact
and Comment section, “Early last year President Vladimir
Putin junked Russia’s tax system and replaced it with a 13% flat
tax…on this issue I never thought I would be outflanked on the
right by a onetime KGB agent.”

It may be wiser to invest in certain foreigners who act more like early
Americans than to invest in certain contemporary fellow “Americans”
who act “un-American.”

TWO BASIC TYPES OF FOREIGN BONDS:

Yankee bonds. These
foreign bonds pay coupons in dollars and mature in US dollars. They
are like domestic bonds, except they might pay slightly higher interest
rates if foreign interest rates are higher. They do not carry currency
exchange risk. The key questions here involve the credit worthiness
of the foreign bonds and understanding why interest rates in a particular
foreign country may be higher than in the US. Yankee bonds are best
for situations where the US is bringing its own inflation under control,
the dollar is likely to hold or gain in value relative to other currencies,
and foreign bonds with higher interest rates are likely to avoid default.
The “golden era” for Yankee bonds began at the peak of double
digit interest rates in the early 1980’s and followed the gradual
decline in interest rates for the following two decades. One class of
bonds, called Brady
bonds, actually carried US Government guarantees.

Foreign bonds denominated in their home currency. These types of bonds
have currency exchange risk. Under certain circumstances, this may be
exactly what you want. The key question here is why the dollar is likely
to decline relative to certain foreign currencies. Foreign bonds are
best for a situation where it looks like the US is going to experience
rising interest rates and inflation, therefore the investor wants to
escape the domestic bond environment to avoid having the value of his
bonds get slammed by rising interest rates. (C.f. my discussion of this
problem in my “domestic fixed income”
article). Since 2000, bonds of countries such as Australia, New Zealand,
and Canada have performed very well, benefiting from the eighteen month
slide in the dollar beginning in late 2001, as well as a reduction in
the Purchase Power Parity (PPP) valuation gaps between the currencies
of those countries and the US dollar (C.f. my PPP-related discussion
later in this section).

A BASIC
ANALYTICAL APPROACH

In trying to find countries whose currencies are likely to appreciate
against the dollar, I usually take two steps. First, I read what experts
in the field say, to include veteran mutual fund managers with proven
track records. John Templeton, who reached age 90 in the year 2003,
is a good example of a veteran fund manager with a proven track record.
I saw him on CNBC in early 2002 where he stated that he was completely
out of the US stock market which he referred to as the “Great
Insanity.” He had bought bonds in currencies he felt were likely
to retain their value, specifically mentioning New Zealand, Australia,
and Canada. I then went the next step and went through the analysis
provided below. I discovered from the Big Mac Index (cited below) that
the currencies Templeton mentioned were indeed considered undervalued.
I discovered from Doug Noland’s Credit Bubble Bulletin that the
US dollar was on a serious inflationary track, and learned from other
sources that the campaign by Clinton’s Secretary of the Treasury
Robert Rubin to artificially strengthen the dollar had finally reached
its “tipping point” and the dollar was likely to commence
a long term downward slide against other currencies. After making a
reasonable effort to try to make sure I was right, then it was time
to go ahead with foreign bonds. Now both I and many of my clients are
grateful that we have been riding a money-making trend for over a year
now.

Whether analyzing domestic bonds, foreign bonds, or stocks, I like
to start with a relatively simple, laissez faire, “ground up”
economic model and then add in the complexities and exceptions. Once
a person understands basic, classical economic relationships, then it
becomes easier to understands how political considerations often turn
these principles on their heads -- in the short run. Let me emphasize
the short run, because in the long run fundamental market principals
tend to be more powerful than various forms of interventionism. In the
long run, market relationships tend to regress back towards basic value
parameters despite all of the efforts of the interventionists to disguise
them. Below I will start with a basic, almost deliberately naïve
“classical” economic approach, and then discuss some complexities
and exceptions.

The analogy between currency value and stock
prices.

In the long run, a unit of currency is similar to a share of stock
in a company. It acts like a share of the economic output of a country
just like a share of stock reflects an ownership portion of the assets
and output of a company. If a country continually adds to its base of
wealth and productivity, and keeps its money supply constant, the value
of each unit of currency will go up proportionally. Something similar
happened to the US dollar in the 1800s when it was on the gold standard.
Despite some war-related inflationary outbursts (the Lincoln Administration
cut the value of the dollar nearly in half during its war against Southern
independence), the dollar was worth about 50%
more in 1900 than it was in 1800.

This analogy may seem a bit strange to contemporary Americans, since
we are so conditioned to ever depreciating currencies both at home and
abroad. Since the creation of the Federal Reserve Banking System in
1913, the dollar has lost over 95% of its value. Europe currencies have
generally been on the skids since World War I. Only Switzerland stayed
pegged to gold up until recently. Despite all of this, please bear with
me.

In the long run, if the value of a currency rises against the currencies
of other countries, this is a good thing, just like a rising stock price
for a company. It means that a country is operating more productively,
is commanding control over more wealth and resources, produces more
goods that others want, and at the same time is respecting the property
rights of its citizens by not depreciating the value of the currency
out from under them. Please recollect that inflation is usually a sneaky
form of taxation, in which the government gets to spend up front what
later becames a real loss in purchasing power for its citizens. Governments
typically resort to inflation because they know they do not have the
political clout to honestly raise funds by formally authorizing new
tax legislation.

This kind of thinking was fairly typical in America and Europe in the
early 1800s when there was a much higher standard of honor and integrity
in society as a whole and government. During this period US and European
currencies generally appreciated over time compared to currencies everywhere
else in the world. As libertarian economist Dr. Hans-Hermann Hoppe
has pointed out, the lights started going out with the advent of World
War I. European countries got off the gold standard to help finance
their continued mutual slaughter in the trenches. Then in the post war
period they toppled the last vestiges of privately owned government
(monarchy and aristocracy) in favor of mass suffrage. They went towards
the other extreme, creating social welfare states where pork barrel
politics became more noble than respecting property rights and private
entrepreneurial capital formation. The cost of government on average
climbed from about 10% to over 50% of GNP.

The fact that virtually almost all advanced industrialized countries
today have a policy of continually depreciating their currencies does
not invalidate my argument, it simply makes it more relative. So in
other words, it is usually a good thing when we find a country that
debauches its own currency at a slower rate than other countries.

Balance of trade surpluses are good and
deficits are bad

If we had a balance of trade surplus, this would mean that foreigners
are demanding more of our goods for export than we are demanding of
theirs. In the long run, this can imply that our goods have a superior
quality to price ratio compared to goods offered by other countries.
Examples on a global level of export goods with high demand can range
from expensive high-end items such as Mercedes cars made in Germany
to relatively cheap items such as computer chips made in China or Malaysia.
As long as a country is steadily increasing the quality of certain goods
while decreasing their relative prices, whether it is focusing on high
end or low end items, and doing this better than other countries, it
should be able to sustain export growth. All other things being held
equal, you want to buy bonds in foreign countries that run sustainable
balance of trade surpluses or at least avoid sustained deficits.

As a rule of thumb, countries with continued deficits over 5% of GDP
are at high risk of seeing their currencies slide against trading partners
with trade surpluses. At some point trading partners get tired of accumulating
excess currency from the country running trade deficits, sell it off,
and drive the value of the currency down. All other things being equal,
you want to avoid buying bonds in countries running chronic trade deficits
since their currencies are more vulnerable to a major correction. .

Just as one generally should stay away from companies that have a
nasty habit of diluting their stock without increasing net asset value
or earnings per share, one should be wary of countries that accelerate
the rate of money supply expansion without any real underlying productivity
growth, asset growth, or other worthy gains. It may take a few years
for accelerating money supply growth
to show up in the inflation figures, but the effect on bond holders
is usually bad. As I mention in my domestic income section, for an American
who owns bonds here in America, the value of his bonds gets hurt in
two ways by inflation. First, inflation erodes the real value of his
coupon payments and the redemption value of his bonds at maturity. Secondly,
rising inflation usually means rising interest rates, which then hurt
the market resale value of his bonds.

For an American who holds a foreign bond denominated in a foreign currency,
something similar happens, only it is a little bit more indirect and
more relativistic. If the foreign country is inflating its currency
faster than the US, then that should eventually hurt the value of the
foreign currency relative to the dollar, and hurt the value of foreign
coupon payments when exchanged back into dollars or the value of the
foreign bonds upon redemption at maturity.

The Purchase Power Parity concept

The idea is fairly simple. It addresses the question of whether current
exchange rates actually allow us to exchange our dollars and buy roughly
the same quantity and quality of goods in a foreign country as we could
buy with the same dollars here in the US. When exchange rates get really
out of whack, supposedly this will tend to self-correct over time through
an international trade environment with relatively low tarriff levels.
Therefore, over the long run, currencies that have large purchase power
parity differentials tend to converge back towards parity. Other things
being equal, I would prefer to buy foreign bonds in First World countries
whose currencies are very much undervalued relative to the US dollar,
and where there are no significant structural reasons why their currencies
cannot revert back to parity with the US dollar.

An interesting application of the PPP has been the “Big Mac”
index developed by The Economist Magazine in 1986. According to “McCurrencies”
in the April 24, 2003 Economist:

Our basket [of
identical goods] is a McDonald's Big Mac, produced locally to roughly
the same recipe in 118 countries. The Big Mac PPP is the exchange
rate that would leave burgers costing the same as in America. Comparing
the PPP with the actual rate is one test of whether a currency is
undervalued or overvalued.

Many readers
complain that burgernomics is hard to swallow. We admit it is flawed:
Big Macs are not traded across borders as the PPP theory demands,
and prices are distorted by taxes, tariffs, different profit margins
and differences in the cost of non-tradables, such as rents. It was
never intended as a precise predictor of currency movements, but as
a tool to make exchange-rate theory more digestible. Yet in the early
1990s, just before the crisis in Europe's exchange-rate mechanism,
it signalled that several currencies, including sterling, were markedly
overvalued against the D-mark. It also predicted the fall in the euro
after its launch in 1999.

Academic economists
are taking burgernomics more seriously, chewing over the Big Mac index
in almost a dozen studies. Now a whole book has been written about
the index* by Li Lian Ong, of the International Monetary Fund. She
says it has been surprisingly accurate in tracking exchange rates
in the long term. But there are some persistent deviations from PPP.
In particular, emerging-market currencies are consistently undervalued.

Everything is relative

What makes foreign bond investing really different from investing
only in domestic bonds is the additional relativity aspect of currency
exchange. For an American holder of a foreign bond, if the US dollar
depreciates more rapidly than a foreign currency, this will probably
be beneficial and more important than the nominal rate of return of
a foreign bond relative to the rate of inflation inside the home country.

A different example of relativity was provided in the interview
by James Puplava on Feb 22, 2003 with Dr.
Marc Faber, editor and author of Tomorrow’s Gold -Asia’s
Age of Discovery. He explained how American holders of Argentinian
assets might have seen net deflation from a currency collapse despite
strong internal inflation. This also provides some other interesting
insights on the inflation-deflation issue.

JIM PUPLAVA:
Let’s talk about a scenario I see developing, which I think
is a very important concept for many to understand. How you can have
existing at the same time, deflation throughout much of the economy
and yet, rising commodity prices? There seems to be many schools of
thought that you are either going to have inflation or deflation.
With the implosion of credit and the contraction of credit that eventually
comes from a bust, you can in fact have deflation, but at the same
time, commodity inflation. Can you explain how both of those can exist
at the same time?

DR. FABER:
First of all, I would like to point out as I explained in the case
of compiling statistics, the concept of inflation or deflation is
very difficult to understand for some people. You can have deflation;
the way the US had deflation in 1929-1932, when the price level fell
by 30%. You can have the Japanese deflation as we had from 1990-2003
where the price level also declined, where the property prices dropped
by 70% and so forth. Another type of deflation is the Latin American
deflation of the 1980s. You have a domestic hyperinflation, meaning
domestically the level of all goods increased, sometimes in Argentina,
sometimes 800% in one year. But because the currency collapsed, you
adjusted for strong currencies such as the dollar at the time and
you had deflation. The currency depreciation exceeded the domestic
price inflation and so you have your deflation through the foreign
exchange market.

I would like
to point out for the European, the US price level last year declined
by 16%, because the Euro appreciated against the US dollar by 16%.
In other words, if I am a European and went to the US 14 months ago,
I paid 16% more than I am paying today because the price level in
the US was essentially flat, but the dollar declined by 16%. In addition
to that, the concept of inflation and deflation is difficult to understand
because, say between 1980 and 2000; you had inflation in financial
assets, in bonds and stocks, where there is inflation in financial
assets. We call it a bull market, but it is essentially the same like
an inflation in commodity prices or an inflation of the Consumer Price
Index. During the same period 1980-2000, we have deflation of all
commodity prices. They all declined dramatically and adjustments for
the Consumer Price Index were extremely low by the year 2002. The
way you could have inflation in financial assets and deflation in
commodities, you could have in the next ten years inflation in commodity
prices and deflation in financial assets. In particular, I think the
bond market in the US is becoming price vulnerable.

HOW FREE MARKET PRINCIPLES GET DISTORTED

As mentioned, although markets tend to win in the long run, the following
are examples of departures from classical theory in the short run that
are often caused by forms of government, central bank, or speculative
intervention or unusual trading relationships.

The analogy between currency value and stock prices.

A country can play games with its currency exchange rates just like
a company can manipulate its stock.

Let me start with a corporate example of stock manipulation. A company
with a dangerously high level of debt might decide to go yet deeper
into debt in order to buy back its stock and drive its stock price higher.
Sometimes insiders do this so that they harvest their stock options
or to fool the public prior to a secondary offering in order to get
a higher price for their stock. This may in fact work very well in the
short run, but in the long it could be a disaster if a company’s
heightened vulnerability to bankruptcy results in an actual default
and reorganization. If a gambit to run up the stock price succeeds,
this reflects financial engineering rather than any real improvement
in the underlying operations, earnings, and other fundamentals of the
company.

Similarly from 1995 to 2000, U.S. Secretary of the Treasury Robert
Rubin pursued a strong dollar policy by buying up dollars. He artificially
increased the value of the dollar against other currencies. It gave
the impression of American economic strength, when in fact America’s
balance of trade deficits kept growing and America kept going deeper
into debt. I invite the reader to look at the upward slopes of the personal,
corporate, and national debt-related charts at the Grandfather Economic
Report web site, and then
consider the long term level of wisdom of Rubin’s maneuver.

Also, in the short run currencies can be heavily influenced by investment
flows rather than physical trade goods, analogous to the way stock prices
can move on flows of speculative capital rather than changes in fundamentals.
As an example, in the late 1990’s, the Australian dollar became
unusually depressed relative to the US dollar because Australians were
investing vastly greater amounts of money in US stocks than Americans
were investing in Australian stocks.

One often hears Wall Street analysts comment that a slide in the dollar
is a good thing, because it makes American exports cheaper and foreign
imports more expensive, therefore creating a self-corrective mechanism
to help eliminate American balance of trade deficits. It is true that
a declining dollar should stimulate our exports, but there is deeper
question here, analogous to the value stock investor who tries to decide
whether a dip in a company’s stock price makes a good investment
a better value, or whether it is symptomatic of a company that is fundamentally
going down the tubes. Unfortunately there is evidence of both in the
case of the US. In the last few decades, manufacturing jobs have declined
from 30% down to 15% of the work force, while America’s total
indebtedness continues to skyrocket. An important issue with companies
is whether they can continually produce goods that have a competitive
price to quality ratio, and whether their internal culture and organizational
discipline allows their workers efficiently reinvest in plant and equipment
and boost their level of skill and innovation. Beyond a certain point,
when the US continues to export manufacturing and service jobs overseas,
this reflects a vote of no confidence or greedy short-sightedness by
American managers regarding their ability to get an adequate payback
from reinvestment in American workers and American infrastructure, and
that is a bad sign.

In discussing exceptions to my currency and common stock analogy, it
is important to address two issues:.

First, please note that there are prominent economists on both the
left and the neoconservative internationalists “right” who
really hate the comparison of currency with common stock and want to
keep this old-fashioned idea flushed down the Orwellian memory hole.
This is because the independent currency concept can become a “territorial
thing” and have right wing nationalist connotations. So, for example,
if certain European countries retain their own currencies rather than
stay blended together under the Euro, and their currencies start to
appreciate, this might give rise to more national pride compared to
other countries that always have problems getting their economic act
together. Pride could possibly lead to more competition and more ethnocentrism
and racism and ultimately maybe even war, conquest, and imperialism.
In order to avoid these kinds of things at all costs, they think the
answer is for all countries to get more laid back and depreciate their
currencies all together or merge everything into one common currency.
This is one reason why the International Monetary Fund forbids countries
from linking their currencies to gold. Depreciating ones currency is
supposed to be cool and trendy, like the folks on MTV who wear hip-hop
grunge and rings through their lips and ears. In Keynesian economic
ideology, this is also supposed to be more humane, because the steady
money supply growth and government spending that leads to steady currency
depreciation allegedly provides more macro economic stimulation to reduce
unemployment.

Another possible exception to the currency and common stock analogy
is the fact that certain Asian countries such as Japan, China, and Malaysia
appear to have vastly benefited from keeping their currencies either
low or pegged to the dollar.

In my view, the real exception has to do with the unique geopolitical
sponsorship that the US has provided these countries, and not with the
underlying economic principles involved. In essence, these countries
have enjoyed a relatively high level of free trade while enjoying dollar
parity, a similar benefit as if their national legal tender were in
dollars. From a purely economic viewpoint, they have enjoyed similar
benefits as if they comprised a 51st state in the Union, or to use a
different analogy, as if they were “East German brethren”
relative to West Germany after the Berlin Wall came down. A corporate
analogy might include the CEO of a company that gives special price
advantages to another company even though it hurts his own company’s
profitability and stock price because of non-business factors such as
nepotism (his son runs the other company), corruption (the other company
is giving him kick-backs under the table, reminiscent of the “Chinagate”
allegations regarding Chinese campaign contributions to the Clinton
administration), or pride and ego factors (the CEO likes to play Santa
Claus).

What is really different from a broad historical viewpoint is that
these Asian countries have been allowed a high degree of national sovereignty
and political-military independence while receiving the economic benefits
of free trade, dollar parity, and intimate export relationships. For
starters, after WWII the US allowed Emperor Hirohito and the Japanese
industrial elite to stay in power and retain control and ownership of
their economic order. The same has applied to China in the post Nixon
era in regard to the Chinese Communist Party and Red Army heirs of Mao
Tse Tung. America has also allowed these countries to retain their own
armed forces and their own racial, ethnic, and cultural homogeneity
and/or their own de facto ethnic and racial balances without demanding
that they accept masses of alien immigrants, eliminate all restrictions
on importing US goods, copy American institutions, accept US work place-related
and union-related regulations, accept permanent US administrators, and
subject themselves to American taxes. In other words, they enjoy all
the economic benefits as if they comprised a 51st state in the Union
dealing in dollars with very little of the real costs and obligations
born by the other 50 states.

Admittedly there have been other countries that have tried to peg their
currencies to the dollar and experiment with free trade, such as Argentina,
and have screwed it up, so I will not take away from the Japanese, Chinese,
and Malaysians the credit they are due for the strong work ethic, social
discipline, and business savvy required to pull off their economic success.
However, their political and economic deal with the US has still been
pretty sweet by historical standards, and this has given them a strong
incentive to keep playing the game and continue keeping their currencies
artificially weak.

Compare all of this to the 19th century, where generally speaking,
in places where British capital built manufacturing facilities and other
business-related infrastructure overseas, one often found the British
flag, British troops, British administrators, British colonists, British
law -- and British taxes. Consider how styles of foreign involvement
have changed. In the 1840’s FDR’s grandfather Capt Warren
Delano
made his fortune trafficking Opium to the Chinese and the British fought
a war in China to keep that market open. In 1900 British, American,
French, Russian, and other troops marched on Peking to suppress the
BoxerRebellion
. American gun boats roamed Chinese rivers, in fact, that is how in
1937 the American gun boat Panay
was accidentally-on-purpose sunk by Japanese planes on the Yangtze River.
Or consider that in order to enjoy freer trade with the US, and remove
an international boycott, white Rhodesians were coerced into giving
up white rule in Rhodesia. Blacks gave Rhodesia the new name Zimbabwe,
and the country has since turned into an economic basket case. Consider
how the U.S. Government pressured white South Africans into relinquishing
control of South Africa, and how that country is currently deteriorating
in the same general direction as Zimbabwe. Consider how white Southerners
wanted to renegotiate their economic relationship with the US Government
in 1861 because they were tired of paying 80%
of the tariff income to the US Government. To add insult to injury,
tariff rates were nearly tripled at the onset of the newly elected Lincoln
administration to about 45%. Lincoln baited the South into firing the
first shots, and his administration proceeded to wage total war. It
destroyed half the wealth of the South, killed one out of four white
southerners of military age, obliterated their elected government (Confederate
States of America), and for many years of the Reconstruction era, Lincoln’s
political heirs prohibited white Southerners from voting as former black
slaves and carpetbaggers ran their legislatures and confiscated their
lands by hiking taxes. To summarize, I think the US Government has been
a lot nicer to certain ruling elites in Japan, China, and Malaysia in
the last thirty years than it has been towards white Rhodesians, white
South Africans, and white Southerners. And getting back to the British,
mentioned at the beginning of this paragraph, I have not even gotten
into the pre WWI history of some stressful British economic relationships
with the Irish, Scots, Boers –or with American Revolutionaries.

Balance of trade surpluses are good and deficits are bad

Trade surplus countries sometimes postpone or intervene to prevent
a day of reckoning for trade deficit countries. This can help to disguise
underlying economic realities for the foreign bond investor who is invested
in a trade deficit country. There are many motivations for why a surplus
country may decide to avoid a mass sell-off of the currency of a deficit
country that would cause a major currency slide. A trade surplus country
might be a staunch ally of country that is inflating its currency and
running huge deficits in time of war, as was the case of the US as the
surplus country during its special relationship with Britain during
World War II. A country may want to help hide economic realities that
could disrupt the creation of an important new alliance. One example
involved the passage of the North American Free Trade Agreement in early
1994. Many major money center banks wanted NAFTA to help stimulate the
Mexican economy to help them recover on their Mexican loan exposure,
regardless of the consequences to US workers, and on top of this the
Clinton administration wanted to pander to the Mexican-American vote.
Not long after NAFTA passed, then Mexico’s current account deficit
chickens came home to roost in late 1994 and the peso collapsed
by 50%. But by then the fix was in. Last but not least, trade surplus
countries may avoid or postpone selling off currency to avoid antagonizing
a Leviathan trading partner. They may also want to keep their export
prices low in order to build up national manufacturing and export infrastructure,
maintain full employment, and out-compete their low cost neighbors.
This is the name of the trade game that Japan, China, and Malaysia play
with the US.

For trade surplus countries, if they don’t “sell it”
(that is, sell off their surplus dollars in the global currency markets
and drive down the value of the dollar), then they may exercise other
options such as “shop it,” “hold it,” or “eat
it” to avoid impacting the currency exchange rates. In regard
to “shop it,” surplus countries can use their dollars to
directly buy US assets, such as stocks, bonds, and real estate, or they
can buy US trade goods they really do not need (US farmers always want
the Japanese to buy more agricultural goods). By “hold it,”
they can simply accumulate more and more dollars, except here they run
the risk that the dollars could lose more value from a continued currency
slide. By “eat it,” I mean cases where the central bank
takes excess dollars presented by merchants and swaps them for the home
currency created out of thin air, which creates inflation in the home
country. In essence the inflation in America that contributes towards
a declining dollar then gets exported into the currencies of countries
pegged to the dollar. Since inflation in the home country tends to depreciate
the home currency, this helps to keep the exchange rate low, and may
even help make the balance of trade surplus even worse. (Henry C.K.Liu,
Chairman of the Liu Investment Group and writer for Asia Times, has
some interesting e-mail discussions under the topic “Bernanke”
about some vicious circles involved in the convoluted trade situation
between the US and Japan at the Post-Keynesian Thought discussion archive).

Sometimes when a country inflates its currency, the impact on currency
exchange rates may not be felt for many, many years. The analogy here
may be a company that can wring out extra concessions from buyers and
suppliers of its products due to some quasi-monopolistic advantage or
some other type of unique position in an industry.

The late French President Charles DeGaulle once referred to the ability
of Americans to cover import deficits with dollars that foreigners were
happy to hold and keep as money as the “exorbitant privilege of
the dollar.” This privilege was based on the status of the dollar
as the premiere global reserve currency.

When excess dollars are circulated within the US, they tend to boost
prices within perhaps a six month to one year lag time. Economists refer
to the rate in which money changes hands as the “velocity”
of money. Inflation is a function of both the total amount of money
in existence and its velocity relative to total goods and services and
productivity within an economy. When foreign banks stash increasing
amounts of excess dollars into inventory rather wash them back at the
US, they are slowing down the global velocity of money. This reduces
the appearance of inflation, and helps to further disguise the vulnerability
of the dollar to a slide in its exchange rate with other currencies.

The Purchase Power Parity concept

The Economist magazine points out that its Big Mac Index has a slight
flaw in that Third World countries tend to show a certain level of sustained
undervaluation:

Differences in productivity
are one explanation of this. Rich countries have higher productivity
than poor countries, but their advantage tends to be smaller in non-tradable
goods and services than in tradables. Because wages are the same in
both sectors, non-tradables are cheaper in poorer countries. Therefore,
if currencies are determined by the relative prices of tradables,
but PPP is calculated from a basket that includes non-tradables, such
as the Big Mac, the currencies of poor countries will always look
undervalued.

LINKS AND OTHER RESOURCES

Free graphical displays of foreign exchange rates around the world
by Oanda.

Economist Magazine country briefings:
After selecting country, click on left “In this country”
toolbar for “economic data.” Figures on current account
balance (balance of trade deficit) and public debt as % of GDP provide
clues about whether or not stress building for a currency devaluation
fault shift.